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Ratio analysis

Ratio analysis is the organisation of information in financial statements to enable or permit entities (I.e. companies, sole traders etc) of the financial statements to deduce conclusions regarding their financial performance.

It is the initial stage in assessing an entity and it serves as a foundation for providing entities with relevant information which aids their decision of what to investigate further.

However, ratios can be expressed as a percentage, as a fraction or as a proportion. They are presented according to the needs of the users of the information.

Although, it is possible to calculate a large number of ratios, not all ratios are beneficial to users. The only ratios that may be worth calculating are those that are based on key relationships and are therefore meaningful to users.

However, there are many groups of people who are interested in using ratios. Some of these groups are shareholders, lenders, customers, suppliers, employers, government agencies and competitors.

Ratio analysis can be used to review trends and compare similar entities with each other in terms of their financial performance. It also simplifies financial statements so that readers can interpret and usefully apply it to their maximum satisfaction which otherwise would have been uninformative and misinterpreted by readers except those who posses very high skills.

Ratios can be grouped into five categories. Each individual category indicates a certain aspect of financial performance. These five categories are profitability, efficiency, solvency, investment and gearing and under these categories are various ratios.

Profitability indicates how well a company is performing. The primary objective of businesses coming into existence is solely depended on profits. Therefore profitability ratios indicates the extent to which this purpose is achieved, taking into consideration the performance of management and a company’s performance relative to its competitors, hence sharing the worth of investing in a company.

Efficiency measures the extent to which resources are utilised by entities to generate output. It may be affected by factors such as shortage of skilled labour or deliberate under production of output to maximise profitability.

The third category is solvency which is also known as liquidity. It is measured by the ability of entities to ensure that their debts are paid at the appropriate time and likewise the ability of debtors to pay the correct amount they owe to entities. This is very essential to businesses as they can only remain solvent by ensuring the availability of adequate resources. Solvency aids in judging whether or not businesses posses a good financial status before being granted loans.

Investment is the fourth category and it indicates the performance of entities in relation to the number and price of their shares and dividends. Last but not least there is gearing which is concerned with the relationship that exists between the financial contribution made by the owners of a business and the contribution by outsiders, and its impact on the financial decision making by managers.

However, under these five categories are various ratios. But for this assignment, I’m going to identify and describe six of these ratios.

The six key ratios are

Return on capital employed (R.O.C.E)

Current ratio

Acid test ratio

Stock turnover

Gearing and price/earning ratio

Firstly, return on capital employed ratio compares the profit earned before interest and taxation to the funds used to generate that return (which is usually the total of all suppliers of long-term finance before any deductions for interest payable to lenders or payments of dividends to shareholders are made).

Therefore R.O.C.E = Net profit

Capital employed

For example If the net profit before interest and taxation of a business was £45,000 and the opening capital employed was given as £00.000. The

R.O.C.E = 45,000 x 100 = 5%

00,000

However theoretically the higher the ratio, the more profitability the resources of the company have been used. Therefore although in my example the ratio is not very high, it is still significant which shows that the business under my example maybe worth while running.

I chose return on capital employed because its very appropriate for measuring the performance of entities as it compares inputs (i.e. capital investment with inputs i.e. profits). It is however very essential because the outcome of the measure (i.e. whether R.O.C.E is adequate or inadequate) is what makes people invest their money in businesses.

On the other hand R.O.C.E is difficult to define unlike the current ratio, therefore one needs to be careful when comparing the R.O.C.E calculated for one company and when reporting it for another.

Secondly current ratio compares total current assets (I.e. cash and those assets held that will soon be turned into cash to total current liabilities I.e. creditors due within one year), which is intended to indicate whether there are sufficient short term assets to meet the short term liabilities. Current ratio is calculated as follows

Current ratio = Current assets

Current liabilities (creditors due within one year)

For example if the total current assets are £60,000 and the total current liabilities are £0,000. This acne be expressed as £60,000£0,000 = 1

Current ratio = 60,000 =

0,000

When dealing with current ratio, the higher the ratio the more liquid the business is considered to be. Therefore a higher current ratio is usually preferred to a lower ratio as it is very important for the survival of a business.

From this I can conclude that the business in my example is worth while as the current ratio is high. However I chose current ratio because it gives an insight of whether resources are being used productively or not, hence giving uses and ideas of whether a business would be worth while or not. On the other hand, it becomes problematic if a business has a very high ratio as this may suggest that funds are being tied up in a cash or other liquid assets and therefore are not being used productively as they might otherwise be.

Another problem with current ratio is the notion of an ideal current ration being 1 as there is failure to take into account the different current ratio requirements for different types of businesses.

Thirdly acid test ratio compares current assets, excluding stock with current liabilities. It is calculated as

Acid test = Current assets (excluding stock)

Current liabilities (creditors due within one year)

For example If the total current assets of a business including stock is £4,000 and are worth £4,000 and total current liabilities are £0,000

The acid test ratio = 4,000-4,000= 0.

0,000

This can also be expressed as 0.1

We can see that the ‘liquid’ current assets of the business under my example do not quite cover the current liabilities, therefore the business may be experiencing some liquidity problems. Therefore the business under this example may not be worth while. However in some types of businesses cash flows maybe strong, in this instance it maybe usual for the acid test ratio to be below 1.0 without causing liquidity problems.

I chose acid test ratio because in some business situations the current ratio may be a less suitable ratio for testing liquidity as it may be better to exclude a particular asset from the major liquidity, the hence the need arisen to use acid test ratio as a measure of liquidity. However that problem with this ratio is that the balance sheet figures may not be representative of that liquidity position during the year as a result of facts as the seasonal nature of such a business.

Fourthly the average which is stock turnover period which measures the average period for which stocks are being held.

Therefore average stock turnover = average stock held x 65 (days in a year)

Cost of sales

For example if the average stock held of a company is £50,000 and the cost of sales are £400,000

Therefore stock turnover period = 50,000 x 65

400,000

= 45.6 days

This implies that on average the stock held is being turned over every 46days.

Businesses prefer a low stock turnover period to a high period as funds tied up in stocks cannot be used for other purposes. However judging the amount of stock to be held, a lot of things have to be taken into consideration such as possible future shortages, future price rises perish ability of products etc.

I chose the average stock turnover as a key ratio because it is useful for company trends over time. Sometimes, there are difficulties in compiling the stock turnover ratio especially if the cost of sales is not available as it is tempting to use sales instead which is wrong as sales are expressed at selling prices and stock is expressed at cost price. Another problem with stock turnover is that the results (I.e. whether there is rising or falling stock turnover) maybe misinterpreted.

Gearing ratio measures the contribution of long-term lenders to the long-term capital structure of a business.

Gearing ratio=long-term liabilities x 100

Share capital+ reserves+ long-term liabilities

For example if the long-term liabilities of an entity was £400 and the share capital and reserves were £500

Then the gearing ratio= 400 x 100

500+400

=44.6%

This ratio indicates that the level of gearing is very high. Therefore, in this particular business, there is a high risk of the business becoming insolvent as the business has a very high financial burden of committing to paying interest charges and capital repayments. I chose the gearing ratio because it is very suitable when analysing entities where the owners have insufficient funds and therefore the only way they can finance their businesses adequately is by seeking external help. However, the gearing ratio becomes problematic when returns generated from borrowed funds doesn’t exceed the cost of paying interest.

The Price/Earning ratio relates the market value of a share to the earnings per share. The ratio can be calculated as

Price/Earnings ratio=Market value per share

Earnings per share

For example if the market value per share in a company is £4.50 and the earnings per share is £0.50

The Price/Earning ratio=£4.50

£0.50

=14.8times

This ratio indicates that the capital value of the share is 14.8 times higher than its current level of earnings. This also shows that there is a high market confidence in the future earning power of the company ,therefore the company under my example will attract more investors.

I chose this particular ratio because it provides a useful guide to market confidence for he future and can be very relevant when comparing different companies.

On the other hand, the possibility of differences in accounting convertions between entities can result in different profit and earnings per share figures and therefore distort comparisons.

Although ratios are useful, they also have limitations. Ratios derieved can be misleading if taken at face value. It is however essential that they are placed in context and that interpretation goes beyond a superficial comparison to general norms as there are different ways of defining ratios. They can also be misleading and therefore result in poor quality decision making as accounting numbers used in ratios are affected by different accounting policies.

We have to take into consideration the fact that no two companies are exactly alike in the nature of their operations and therefore comparisons must make allowances for different types of businesses. Also, many companies operate in more than one industry so that comparison with industry norms has to be treated with care.

The balance sheet is only a snapshot in time and does not represent the year as a whole so ratios should not be relied on exclusively as doing so may result in loosing sight of the information in the financial statement. We also have to bear in mind that ratios are an initial stage from which to identify further questions and are exclusive of answers. Most importantly, ratios are also based on financial statements and are therefore dependant on the quality of the financial statements.

Last but not the least, care should be taken when stating ratios to show the form being used. Examples as a proportion-as in current ratio 1,as a percentage- as in R.O.C.E. of %.

In conclusion, we can see that ratios aids in analysing the different aspects of the position and performance of entities. Therefore they can be very useful and give us an insight of a business if used appropriately. It also explores the problems arising due to a business performing too profitably (overtrading). In other words ratios can be used to detect overtrading.

Although, ratios make obvious the strengths and weaknesses about financial performance and position, they do not identify underlying causes However this can be done through a thorough investigation of business practices and records.

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